Elasticity

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    Elasticity

    • We have no covered how much demand and supply changes when any factors, including price of the product changes.
    • This is where the concept of elasticity comes in, which is:
      • A numerical estimate
      • It measures the response to a change in price or any other factors that determine the demand and supply of a product
    • Elasticity explains things like:
      • The price of a summer holiday in May or June is around 2/3rds of the price it is in August
      • The demand for some products increases more than others when real disposable income increases
      • It is often difficult for suppliers to respond quickly when there is a surge in demand for their products.

    Price Elasticity of Demand (PED)

    • PED measures how responsive the quantity demanded of a product is to a change in its price
    • All other factors that affect demand are assumed to remain unchanged
    • Mathematically, it is no more than the gradient of the demand curve
      • For example, supposed a tour operator sells 5,000 holidays a month to Ibiza for a price of £400.
      • When the price is increased to £440, the demand falls to 4,000 holidays per month
      • So:

     

    • This estimate of -2 indicates that the demand for holidays to Majorca is responsive to a change in the price of these holidays
    • This is known as a price elastic of price sensitive situation
    • The negative sign just shows that the quantity demanded has fallen as a result of the increase in price

     

    • Not all products we buy are very responsive to a change in their price
      • For example, if the price of household water were to increase by 10%, demand would hardly fall – maybe by 1%
        • This would produce an estimate of PED to be -0.1
        • This is price inelastic or price insensitive, meaning that the quantity demanded is not particularly responsive to a change in its price

     

     

     

    • If PED > 1 – elastic
    • If PED < 1 – inelastic
    • If PED = 1 – unit PED (change in price causes a proportional change in demand)

     

    • Variations in PED lead us to ask the question: ‘What determines the price elasticity of demand for a product or group of products?’
    • There are three main determinants:
      • The availability and closeness of the substitutes
      • The relative exposure of the product with respect to income
      • Time

     

    • We know that a substitute is an alternative to a particular product
    • In general, the greater the number of substitutes and the greater their closeness to a given product, then such a product is likely to be price elastic
      • An example is baked beans
        • There are many brands that are similar to each other, and so a rise in the price of one brand would result in a steep fall in demand, as more consumers would be buying other brands

     

    • If a product takes up a very small percentage of a consumer’s income (e.g. a banana) – the doubling in price wouldn’t affect the quantity demanded that much –it’d be price inelastic
    • The reverse is true
      • If a product takes up a large part of a person’s income, then its demand would be more sensitive to a change in price – it’d be price elastic

     

    • Time also plays a part, as it takes a while for consumers to change their spending habits
    • As a result, they are quite likely to continue to purchase a product despite a price increase
    • Over time, however, as consumers find out more about other substitutes, demand for a product is likely to become more price elastic.
    • Also, where consumption of a product can be delayed (new car, new kitchen), demand for that product is likely to be price elastic.

    Income Elasticity of Demand (YED)

    • The sign is important, as it indicates whether there is an increase or decrease in the quantity demanded following a change in income

     

    • Most products have a positive YED – these are called normal goods
    • This means that as real disposable income increases, demand for these products will also increase
      • g. holidays, wine, clothes, electronics, etc.
    • The extent of the response of demand to the change in income can vary.
      • Two examples are:
      • Where the estimate of income elasticity of demand is < 1 –income inelastic
      • Where income elasticity of demand (YED) is > 1 – income elastic

     

    • Some goods have a very large income elasticity of demand – these are called superior goods
    • Demand for them increases considerably more in relation to the change in income
    • Definitive examples are hard to list, as it is subjective.
    • What is a normal good for one person could be a superior good to a person on lower income

     

     

     

     

    • Examples of inferior goods are own-brand supermarket products, second hand goods, coach travel, etc.
    • Better substitutes are available, but for a family on low income, such alternatives are out of their reach.

    Cross Elasticity of Demand (XED)

    • XED is derived from what was previously stated – that the price of substitutes and complements can affect the demand for a particular product

     

     

    • It measures the relationship between two different products, so the sign and size of the XED are relevant
      • A positive estimate indicates that the two products are substitutes
      • A negative estimate means that they are complements
      • A zero estimate means that there is no particular relationship

     

    • The size of the XED indicates the strength of the relationship between a change in the price of one product and the change in demand for another product
    • Where products are good or close substitutes, the value of the XED will be higher than if they are only modest substitutes.
    • Similarly, for the complements, a high value of XED is indicative of products with a high degree of complementarity.

     

     

     

    Price Elasticity of Supply

    • Price Elasticity of Supply (PES) is the supply equivalent of PED

     

     

    • PES indicates how much additional supply a producer is willing to provide for the market following a change in the price of the product
    • Given that the supplier wants to maximise profits, it follows that the PES will always be positive
    • Obviously, if the price falls, it would be unusual for the supplier to produce more goods for the market in a free market solution

     

    • The size of the PES is therefore very important, and can take the following values:
      • Between 0 and 1
        • This means that the PES is inelastic
        • Supply is not very responsive to a change in the price of the product
      • Greater than 1
        • PES if elastic
        • Producers are able to respond with a relatively large change in supply if price rises
      • Equal to 1
        • A change in price causes an exactly proportional change in the quantity supplied

     

     

     

     

     

     

    • In practise, suppliers are not always able to respond to a change in price with the same speed as consumers
    • This is because for most products, it takes time for producers to alter their production schedules in response to market need, unless they can draw upon stocks.
      • For farmers, this time lag could be as much as a year – the time it takes to alter the mix of their production

     

    • Large parts of the service sector face a rather different supply issue.
    • In the long term, the supply of their products is more elastic than in the short term
      • In the case of hotel or air-craft, supply is perishable as the product can’t be stored
      • If a hotel room is not sold on a particular night, this represents a loss to the business.

     

    • So there are three main factors that determine the PES of a product:
      • Availability of stocks of the product
      • Availability of factors of production
      • Time period

     

    • Stocks or inventory allow supplies to store products in a warehouse
    • This relates to elasticity of supply as they can be quickly distributed if demand increases and henceforth price
    • Equally, if price falls, goods can be stored, depending on how perishable they are
      • For example, supermarkets like ASDA carry a certain amount of ‘buffer stock’, which can be released if market conditions change
      • For service sector businesses like hotels, supply is infinitely inelastic since the product cannot be stored, it has to be consumed on a particular day or time period otherwise it is lost.

     

    • With regards to the factors of production and its effect on PES, labour is usually the most available.
    • Provided there is spare capacity, additional works can be used to increase output, often in a short time span
    • Here, elasticity of supply is relatively elastic
    • For some businesses, it is the availability of capital that determines whether a firm can increase output
    • When new machinery has to be purchased and installed, the elasticity of supply will be inelastic
      • The risk is that market conditions may change before any increased production can reach the market

     

    • With regards to time, where it takes a long time for supply to be adjusted, supply will be inelastic
    • In the longer term, however, supply will normally be more price elastic
      • An example is travel companies – they have to reserve flights up to a year in advance for some consumers – making supply price inelastic
      • The problem companies then face is if demand is low, they are left with unsold holidays
      • Price will therefore have to fall in order to clear excess supply

    Business Relevance of Elasticity Estimates

    • Elasticity measure have considerable practical business relevance
      • For example, knowledge of PED is an essential input when a firm is generating a pricing strategy which enables them to maximise sales revenue.
    • But how might this data be collected and what are the general limitations of elasticity data?

     

    • All elasticity measures require information to be collected at two separate points in time
    • The formulas make this clear by indicating that ‘change’ is being measured

     

    • The information can be collected by means of:
      • Sample surveys of consumers (price and YED)
      • Past records from within a company (PES)
      • Competitor analysis (XED)

     

    • Given the nature of how the data is collected, it is necessary to appreciate that:
      • The data gathered will be estimates, since the data collected might be inaccurate
      • Over time, there could be other factors that aren’t in the forecast that affect the demand of supply of a product
      • Prices may fall due to this, which produces an unfair elasticity estimate

    Use of PED

    • PED is widely used by businesses when pricing their products in the market
    • It is evident in the transport market where the market’s segmented on a time basis

     

     

    • In applying market knowledge of PED, companies are pursuing an objective of maximising revenue
    • Companies are aware that where demand is inelastic, an increase in price leads to an increase in total revenue.

     

     

     

     

     

    • The business situation in both graphs is clearly beneficial, as revenue increases
    • What is not beneficial is for a firm to reduce prises if demand is inelastic or to increase prices where demand’s elastic

    Use of Income Elasticity of Demand

    • In most economies, real disposable income tends to rise over time
    • This is significant to businesses that produce goods and services because with a highly positive YED can expect to do well in the future
    • Oppositely, firms producing goods with a negative YED might do badly
    • An exception to this is where a business changes the image of a product so that YED becomes position
    • Upmarket baked beans and spam are examples, as they’re not marketed as superior, but used to be inferior products

     

    • In economies such as the UK, where living standards continue to increase, there has been a growth in markets in the service sector, such as overseas holidays, eating out and health spas.
    • So these types of businesses would seem to have good business prospects in the long term
    • Estimates of YED can provide a basis for forecasting market demand

     

    • When economies force uncertain short term economic prospects, then demand for income elastic products will fall
    • This is because consumers are forced to substitute their demands towards inferior goods and services
    • Products with a low YED are unlikely to be affected by a rise or fall in living standards

    Use of Cross Elasticity of Demand

    • Estimates for XED are useful in competitive markets
    • Where there are close substitutes, and hence a high positive XED with other products, then the firm are likely to cut prices to increase market share
    • This occurs in practise between:
      • Low cost airlines, train and bus companies on identical routes
      • Well known brands of identical grocery or electronic products
      • Products such as wine and butter that are produced in different companies but are virtually the same
    • In such cases, there are close substitutes
    • Increasing prices is dangerous, as you can lose market share to a rival, which is difficult to regain

     

    • The case of compliments also has implications for firms
    • This is because the price of two complimentary goods may not be close
    • Here, XED will be high and negative

    Use of Price Elasticity of Supply

    • PES is always positive – it shows the affect of the relationship between price and quantity supplied
    • In many types of business, supply is price inelastic in the short term, as it is often difficult to switch resources into a market
      • An exception to this is firms that hold onto stocks in anticipation of a price rise
    • In the long term, however, supply is more likely to be price elastic as resources can be re-allocated to respond to the increase in market price

     

    • In general, firms will try to make their supply as elastic as possible, as they want to increase sales to maximise profits
    • If prices are falling, an elastic supply will enable them to move resources away from such products and into alternatives where there’s a normal relationship between a change in price and the change in quantity supplied.

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